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Notes on the continuing crisis

Securities markets have witnessed some extraordinary disorder in recent weeks. Back in early May there was the stomach-churning “flash crash” on the New York Stock Exchange, when some as-yet-unexplained disruption triggered a brief but precipitous collapse in US equities. One stock, over the course of a few minutes, literally zeroed out: technically the company’s equity capital vanished. Even a number of large and stable industrial firms absorbed a hit to their stock that seemed unimaginable. Conjecture on the cause of this shock centers around computerized trading models, which operate on complicated algorithms to execute stocks trades in fractions of seconds.

I’m not sure what the current theory is, but for awhile it was thought that someone blundered into a mistakenly enormous sell-order of Proctor & Gamble stock (billions of shares instead of millions); P&G being an major component of thousands of managed portfolios, its sudden drop in value activated automatic sell-offs in dozens of other stocks; and before anyone could blink, billions upon billions in paper wealth was gone. The SEC and other regulators have subsequently canceled many of these trades, but for a few hours there the extreme fragility of finance capitalism was brought home in a brutal way (again) to every trader around the world.

More worrisome have been the persistent dislocations in Europe. The problems there are deeper and more portentous than any algorithmic disruption. The “periphery” nations of Europe, above all Greece, have touched off a more general flight from sovereign debt assets. In simple terms, investors have become intensely fearful that these heavily indebted countries — Greece, Portugal, Spain, Ireland, Italy, even the UK — will not be able to pay back the capital they have borrowed to fund (a) recent bailouts of their financial sectors and (b) their lavish welfare benefits. Multiple rescues of Greece were announced over the course of the spring, with little lasting effect. Finally, about two weeks ago, European leaders unveiled what has been called the Euro-TARP: a package of rescue loans and other devices weighing in at over a trillion dollars.

The European Central Bank was active in this as well. First it announced that it would accept Greek bonds as collateral in its liquidity facilities. That alone was an important step, because these bonds were precisely the securities that were tanking: they were the bonds that very few private actors would accept as collateral. Next the ECB activated a program of “quantitative easing,” meaning that it would openly purchase Greek and other sovereign debt instruments. That momentous measure came out alongside the Euro-TARP.

Even all this intervention, much of it unprecedented, did not really calm capital markets in Europe. There have been rumors, beginning last week, that the ECB and other central banks are intervening in bond markets still further, this time quietly (by what arcane mechanisms I can only guess) — all with an eye toward a gradual and orderly decline in the euro against the dollar and Asian currencies.

The US has been (so far) spared the kind of disruptions Europe experienced, but given the volatility we’ve seen, who can be confident this will last? These disruptions could easily derail our rather anemic and government-driven recovery. A stronger dollar vis-à-vis the euro hurts our exporters; and high-end manufacturing, which are heavily-dependent on exports, is one sector that has shown some real life in recent months.

More ominous still, sovereign debt fears in Europe augur the same over here. The US may not be as heavily indebted a Greece or Spain, nor is our welfare sector quite so generous (we do not yet pay public sector employees lavish retirement benefits in their early fifties, or distribute to them 14 “monthly” paychecks), but we’re not far away. Both the current and the previous administration have been downright profligate, expanding domestic programs and undertaking hugely expensive foreign adventures. We are shielded from the immediate consequences of this profligacy by both the fact that the dollar is still the world’s reserve currency and the fact that dollar-denominated debt assets, still seen as the least risky around, benefit from investors’ flight from risk.

For me the takeaway from all this is two-fold:

(1) The economic environment is still strongly deflationary. Financial assets are losing value. Even the vast flood of new dollars, euros, pounds, yen, etc., has failed to prevent these losses; it has only managed to delay and dilute them.

(2) The crisis in confidence is shifting from private (above all banking) assets to public assets. Having rescued finance capitalism from insolvency in 2008, governments are now feeling the sting themselves. They themselves may not be solvent.

Finally, it will come as no surprise to What’s Wrong with the World readers, but all this disorder only confirms my judgment that globalization has been a ruinous boondoggle. We might say that the European Union is the quintessential institution of globalization. In financial terms it can be seen as the project to allow Greece, Spain, Italy and other countries on the periphery of Europe “borrow” the balance sheets of Germany or France in order to issue debt to fund their entitlement programs. In other words, the weaker nations of Southern Europe could borrow at German rates. There is your integration of capital markets in bald summary. In the US, globalization allowed us to export our consumer demand around the world, and bring in capital in return. This capital went chasing after ever higher yields. If you ever read an article on exotic bond market instruments and wonder how the hell these financiers could get away with constructing these bizarre things — synthetic securities confected out of derivatives attached, off at the end, to a tract of houses in Florida or Arizona sold to unemployed single mothers or college students — you may find your answer in the insatiable hunger for higher yields. Pension plans built on assumed 8% annual returns will not be satisfied with a basic mortgage-back security; they need more risky instruments to reach that sort of yield. Indeed, to my eyes the role of institutional investors — pensions, sovereign wealth funds, endowment funds, etc. — in driving the crisis of finance has been unwisely neglected. But it was only possible for this capital to go racing around the world after yield, mouse-click by mouse-click, because capital markets were growing ever more integrated. This liquidity in bond markets was the authentic and intended consequence of globalization. It had the effect of wildly inflating financial assets around the world. Capital could be lent by some small town in Australia with an investment fund, and almost instantly appear, through intermediaries in London and on Wall Street, for use in the digital coffers of mortgage finance companies in Southern California. What was not intended was the bankruptcy of said Australian town when the California mortgages went sour.

Now all these assets, inflated by the novelty of bond-market liquidity and the illusory stability of global integration, are deflating; and there ain’t much anyone can do about it.

Comments (21)

Paul,

You say, "Capital could be lent by some small town in Australia with an investment fund, and almost instantly appear, through intermediaries in London and on Wall Street, for use in the digital coffers of mortgage finance companies in Southern California. What was not intended was the bankruptcy of said Australian town when the California mortgages went sour."

I say, how is this any different (other than the fact that it is occuring globally) than Jeff Singer putting his 401K savings into a mortgage finance company here in Chicago run by Tony Rezco and then when Tony's mortgages go sour, I lose my savings? In other words, when it comes to investing, there are no guarantees.

That town in Austalia could also have bought Google stock back when they had their IPO and made out like bandits -- are you going to denounce globalization for all the winners as well as the losers?

Finally, is gloablization the real problem or has it simply enabled the real problem which I think you identify above: profligate spending by governments.

Oh, there are countless guarantees. For big corporate finance units and banks especially.

Southern Europe could not have been nearly so profligate if the EU monetary framework had not enabled those countries to borrow like they were cautious Germans. The US could not have been so profligate had its economy not been integrated with mercantilist powers (in Asia particularly) willing to extend the capital to fund its profligacy. Globalization and profligacy are symbiotic.

The one outlier is Japan, where profligacy (of a sort) has proven stable because the borrowing comes from extant domestic savings.

We might say that the European Union is the quintessential institution of globalization.

But Paul, surely you know that all of us black-helicopter-watching conservatives hate the EU and always have for reasons of loss of national sovereignty, etc. Remember how Maggie Thatcher wasn't exactly thrilled about the EU, either. I think here of the way in which (as I posted about) Switzerland was brought to its knees by other EU countries for attempting to require a Libyan "prince" not to beat people up _in Switzerland_ and for attempting to keep Libyan terrorists out of Switzerland. It was that bad. The EU was all on the side of Libya, and Switzerland caved.

What I don't understand, exactly, is why you seem only to think of the evils of a transnational government like the EU in terms of "globalization" from a financial perspective when there are and always have been so many other reasons to oppose such a thing.

I think it's terrible that Germany got dragged into Greece's mess. All the more reason for all those countries to have rejected the EU to begin with.

What I don't understand, exactly, is why you seem only to think of the evils of a transnational government like the EU in terms of "globalization" from a financial perspective when there are and always have been so many other reasons to oppose such a thing.

It's just that the financial angle has given me new insight into the workings of this trend. Big parts of it were mysterious to me. The financial aspect, for example, sheds light on why so many mainstream conservatives maintained a curious silence on globalism.

"Deep down, the crisis is yet another manifestation of what I call “the political trilemma of the world economy”: economic globalization, political democracy, and the nation-state are mutually irreconcilable. We can have at most two at one time."

I guess we need to agree on what we mean by globalization -- the effort to break down trade barriers and make it easier for individuals (and businesses) to freely engage in commerce with one another across great distances and despite differences in language and culture seems to me on its face a nobel achievement. The effort to force a country to give up its sovereignty for benefits its citizens don't want -- not so good. So there are trade offs.

Anyway, I just came across this paper that I know you'll want to read:

In this paper, I argue that public-policy decisions have perverted the incentives that naturally create stability in financial markets and the market for housing. Over the last three decades, government policy has coddled creditors, reducing the risk they face from financing bad investments. Not surprisingly, this encouraged risky investments financed by borrowed money. The increasing use of debt mixed with housing policy, monetary policy, and tax policy crippled the housing market and the financial sector. Wall Street is not blameless in this debacle. It lobbied for the policy decisions that created the mess.

I've given my working definition of globalization a number of times now: the integration of world capital markets. I think this is broad enough to encompass most of its aspects, both economic and political; but still precise enough to be useful.

I think my definition has an advantage in terms of clarity over the standard definitions that focus on trade. For instance, it makes little sense to talk about you or me, on the level of individuals (or even on the level of most businesses) having "free" trade with China. The best we could do to get exposure to yuan-denominated assets is invest in an emerging market mutual fund or something, which would of course have us also exposed to Thailand, Brazil, South Korea, etc. But it makes fine sense to talk about the integration of American and Chinese capital markets. The relatively small collection of institutions that facilitate this integration (much smaller since the brutal culling of competitors in 2008) have a freedom that no individual or small business can even imagine.

The greatest achievement of globalization, by my reckoning, is how much capital it does make available. Thousands of business enterprises were funded that would not have otherwise been. This came with costs, which I have attempted to adumbrate here and elsewhere, but I think it must be counted a very real benefit.

I'll check out that housing paper, though I must confess that it will be with some weariness. For one thing, one can only read this tale's telling so many times before ennui sets in. For another, it seems to me that housing was simply the trigger for the crisis. Without the enormous infrastructure of debt securities surrounding it, the infrastructure by which capital markets were integrated, it is doubtful that the crisis would be so severe, nor the government interventions so broad and deep.

Pension plans built on assumed 8% annual returns will not be satisfied with a basic mortgage-back security; they need more risky instruments to reach that sort of yield.

Before the 2008 crash, one favorite pro-capitalist talking point was how, if an 18-year-old could just make a one-time investment of $10,000 at 10% annual compound interest, he'd be a millionaire by the time he hits 68. Was that ever realistic?

Professor Antal E. Fekete, Hungarian born but teaching in Canada, is something of a neo-Austrian in his economic philosophy and has written extensively about what he calls "malevolent bond speculation" and its sources. From a paper he wrote in 1996:

In the economic literature it is customary to make a distinction between stabilizing and destabilizing speculation. The distinction is spurious. All legitimate speculation is stabilizing, if by `legitimate' we understand speculation addressing risks inherent in nature (e.g., weather, natural disasters, etc.) By abuse of language, the word `speculation'
nowadays is applied to market activity that addresses risks presented not by nature but by arbitrary government action. However, a word already exists in the dictionary to describe
this kind of activity, namely, gambling.

Properly understood, under the regime of irredeemable currency participation in foreign exchange and bond markets (including derivative markets in futures and options) is not speculation but gambling. The risks involved have been artificially created by arbitrary measures. Just as increased participation at the roulette table cannot reduce the risks of betting (and can often increase them) increased `speculation' in the bond markets cannot
reduce price fluctuations (but is more likely to increase them).

Under a gold standard speculation in grains is economically justified by the existence of future uncertainties presented by nature. In the case of an unexpected crop failure or bumper crop the price disturbance is minimized by the presence of a speculative supply or demand. No such justification for bond speculation can be offered. All the risks are wholly artificial and cannot be reduced by inviting speculative participation.

On the contrary, price-swings are likely to increase along with increased participation. This is a case of pure gambling. The linguistic innovation of calling it `speculation' will not change its nature. Government economists suggest that the derivative markets in interest-rate futures have the same salutary effect on interest rates as future markets in grains have on grain prices. There is not the slightest evidence to support this claim. The effort to smooth out interest-rate fluctuations under the regime of irredeemable currency by creating more opportunities for bond speculation and for trading derivatives in interest-rate futures is doomed. Opening ever more derivative markets will backfire.
More gambling creates more uncertainty, not less. The regime of irredeemable currency is characterized by insufficient capital accumulation or maintenance and, ultimately, by capital destruction. It cannot be rescued by legalizing gambling.

The `Dance of the Derivatives' of 1994-95 gave a foretaste of what is to come. Banks, commission houses, pension funds, and even municipal governments are known to have gambled and to have suffered grievous losses, some irreparable. Observers blamed the
debacle on inept or dishonest traders. A more adroit analysis would, however, show that disaster had to strike in any case. The same thing would have happened even if traders had been meticulously following the traditional methods of hedging and arbitrage.

The truth is that the old rules no longer apply. Once the sheet anchor of gold has been removed, the character of the game has changed beyond recognition. Previously gold acted as the policeman keeping speculators in line. Because of the presence of gold in the system, the speculators could gang up in order to bid up commodity prices, or to drive down foreign exchange rates and bond values, only at their own peril. Their bidding would immediately be confronted with relentless arbitrage, exacting a heavy penalty for reckless bidding. Arbitrageurs could count on gold, the policeman of the system, in resisting recklessness in speculation.

But with the policeman fired and no replacement commissioned, speculators can gang up with impunity, induce and ride price trends unilaterally, until they are ready to make a killing. Speculation has become malignant. Speculators ran up the price of sugar to 75 cents a pound and that of crude oil to $42 a barrel -- and made money all the way up. They drove down the price of a $1,000 Treasury bond to $500 and t he yen-price of the U.S. dollar to 78 -- and made money all the way down. And they made a killing when they sold sugar at 75 cents, crude oil at $42; and when they bought Treasury bonds at $500, the U.S. dollars at 78 yens.

During these episodes arbitrageurs have been conspicuous only by their absence. They are intimidated in the absence of the police, and are gradually withdrawing their services. When the last arbitrageur abandons the market, the speculators will have a field day. They will bid commodity prices up to the sky, and drive currencies and bonds to the ground. Without the guarantees of the gold standard, no arbitrageur will be able to oppose the speculators when the bull-run in commodities and the bear-run in securities start in earnest.

Before the 2008 crash, one favorite pro-capitalist talking point was how, if an 18-year-old could just make a one-time investment of $10,000 at 10% annual compound interest, he'd be a millionaire by the time he hits 68. Was that ever realistic?

That supposed "talking point" isn't so much pro-capitalist as pro-math, seeing as how it's just an observation of an obvious numerical reality. If such an investment exists, then it's a good one, though I doubt very much that any reasonably informed "pro-capitalist" would have said that the market abounds with such investments, much less claimed that their hypothetical possibility justified any actually existing state of affairs. I'd welcome citation to the contrary, which ought to be abundant, as is usually the case with talking points.

I doubt very much that any reasonably informed "pro-capitalist" would have said that the market abounds with such investments, much less claimed that their hypothetical possibility justified any actually existing state of affairs. I'd welcome citation to the contrary, which ought to be abundant, as is usually the case with talking points.

Agreed that no reasonably informed pro-capitalist would make this argument. But I recall Michael Medved putting forward this optimistic scenario on his radio show, and it was bouncing around the internet some time ago.

A simple google search on '"compound interest" ten percent' yields plenty of examples. It looks like the ten percent figure is used often in educational textbooks, likely because of the ease in multiplying or dividing by tens.

Jeff: I guess we need to agree on what we mean by globalization -- the effort to break down trade barriers and make it easier for individuals (and businesses) to freely engage in commerce with one another across great distances and despite differences in language and culture seems to me on its face a nobel achievement.

Paul: I've given my working definition of globalization a number of times now: the integration of world capital markets. I think this is broad enough to encompass most of its aspects, both economic and political; but still precise enough to be useful.

Paul, I have to say that your definition appears to be "political" only in the sense of dealing with the politics of high level finance. It is not political in a broader sense, such as the politics surrounding intervention in failed states or genocide, or the politics that determine general loss of sovereignty, or government regulatory theory, or crime and punishment, etc.

Globalization, in a general and theoretical sense, ought to be a term broad enough to cover much more than just finance. What about Bill and Melinda Gates' project to stamp out malaria in the third world? Or projects to bring education to the Innuit by the internet? Or the development of village-level crafts and arts for sale a continent away? These are not primarily changes having to do with international finance, and yet are surely aspects of globalization. Anything that deals with more readily bringing together peoples, activities, events, goods, or ideas, from distances over a couple thousand miles, is something that affects the globe getting smaller in a practical sense. That's what globalization means at root. Capital is one (important) part of that, but not the only one, and not finally the essence of the whole shebang. Capital is a tool that is involved in some of these efforts, but it is far from the only one, and it is NOT important in all such efforts. Therefore a focus on capital as such is overly narrow.

I agree with everything you say. I think Paul should modify his critique into a more narrow one in which he is specifically focused on "the global finance system" or something like it, rather than confuse us all by throwing the loaded term "globalization" around, which does in fact mean much more than the integration of world capital markets.

Quite frankly, it would set off fewer alarm bells in me and make me more sympathetic to the targeted reforms.

I'll think on that, guys. I'm concerned that your definition is overly broad. Globalization then becomes something like "widespread interactions among peoples and individuals." We might as well talk of the globalization effected by the Roman Empire, which gave Saint Paul the liberty to preach the gospel around the known world. That might be a serviceable definition, but I think we've then left behind the strongly economic connotations the word usually is meant to invoke.

Paul, I would suggest that the globalization effect is found wherever you have people from widely separated parts of the globe interacting in a way that they almost certainly wouldn't have 20 or 30 years ago. For example, My family started writing to a seminarian in Ghana, Africa some 15 years ago. At that time, we wrote letters about once every 4 or 5 months. He could only call us if he was visiting the big city. Now, because cell phones are virtually as cheap there as here, he can call us, and we send pictures back and forth by email in just minutes if need be. Our world is smaller, the mental and practical distance contracted over that 15 years to the point where our being in contact is quick and simple, rather than difficult and slow. And that change has virtually nothing to do with capital on an international scale (at least directly: admittedly, the international communications system would not have spread as rapidly without global capital, but that is probably the LEAST inappropriate place global capital was used, and the market has paid off that debt quite thoroughly).

There is certainly a sense in which the Roman empire encouraged some "globalization": the granaries of Egypt helped supply the Roman legions in far off places, due to the excellent roads and mostly safe shipping of the Pax Romana. The silver mines of Spain had markets in the East. Rome made the distances less important.

I think, Paul, that perhaps the kind of globalization you want to focus on is the predominant mechanisms of globalization that sort of set a paradigm for how it is coming about practically during the last 20-30 years: specifically a set of interlocking mechanisms of trade, labor, finance, and government interactions which supported a mental outlook of greed, short-sightedness, tall-tale telling, a willingness to use people, and so on. But globalization would have still been happening even if we had not chosen to embrace this particular paradigm for it - it would have happened under some other set of mechanisms, perhaps some not so readily supporting short-sighted greed.

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